Carbon allowances, state tax credits and REITs
REITs can treat income related to some state tax credits and carbon allowances as good income, the IRS said.
REITs are corporations or trusts that do not have to pay income taxes on their earnings to the extent the earnings are distributed each year to shareholders.
However, they must be careful to ensure their assets are largely real estate and their income is largely passive income from the use of real estate.
There are both 95% and 75% income tests. At least 95% of the REIT’s gross income each year must come from dividends, interest, rents from real property, or gain from the sale of stock, securities and real property. At least 75% of gross income must come from rents from real property, interest on mortgages secured by real property or gain from sales of real property.
“REIT” stands for real estate investment trust. Gas pipeline companies that had been organized as master limited partnerships — large partnerships whose units are traded on a stock exchange — have been looking lately at converting to REITs as interest in MLPs wanes.
Three REITs that own timberlands asked the IRS for private letter rulings this year that carbon allowances the REITs receive and then sell in state cap-and-trade programs as part of state-level efforts to limit carbon emissions are good income for REIT purposes. The IRS made the rulings public in December.
The REITs report the allowances as income upon receipt.
Each of the states where the timberlands are located places a limit on the greenhouse gas emissions that it permits each year. Companies must buy allowances to cover their emissions.
Trees absorb carbon dioxide. Anyone owning a forest is considered to be taking steps to reduce carbon emissions. The state enters into protocols with such persons requiring them to take certain steps, including to monitor and verify the amount of carbon sequestration occurring, in exchange for which the state awards one allowance for each metric ton of carbon dioxide sequestered. The allowances can then be sold for cash to other companies that need them to cover their emissions.
The IRS analogized the arrangements to granting the state an easement over use of the forest. The allowances are rent. The forest owner must agree to restrictions on how it can use the land. The land-use restrictions can be recorded as an easement under local law. Consequently, the income from the allowances is close enough to rent for use of real property to qualify as good income for a REIT.
The rulings are Private Letter Rulings 201949004, 201949005 and 201949007.
Another REIT asked about a state tax credit that it will receive for investing in a partnership that is developing a real estate project in a low-income area. The partnership was awarded a tax credit for a percentage of its capital investment in the project, up to a cap. The tax credit is transferable, but not refundable. The partnership plans to sell it and report the sales proceeds as income.
The IRS said the income from the tax credit sale is good income for purposes of both REIT income tests. The tax credit is part of the return the REIT will receive on a real estate investment. The ruling is Private Letter Ruling 201948006. The IRS made it public at the end of November.